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October 26, 2015

This tweet was
prompted by the debate – online, and sometime offline between the different
approaches to value investing. These debates appear like religious arguments
with each side claiming their god is the superior one.

I have never
quite understood the point of these debates.There is obviously no single way of making money in the stock market.
There are short term traders, buy and hold guys, debt specialists and all kinds
of people in-between. Each approach has its strengths and weaknesses and no one
can claim that a specific approach is inherently superior to the other, unless
they are equally proficient in both.

I have come to realize
that the most important factor to long term success is to understand which
approach suits your temperament.

The value of learning

Some of you who
have followed me on my blog, would have noticed that I try not be a dogmatic
about any specific style. I have tried multiple approaches and continue to do
so. I do have a dominant style which suits my temperament – buy decent quality
companies and hold them for the long run, but I have tried deep value,
arbitrage, options and all other types of investing.

Most of my
experiments have been failures (see here and here) from a monetary perspective, but they have deepened my
understanding on what works and does not work for me.

A valid
question would be – why bother? Why not find an approach which works for you
and then just stick with it (and maybe even publicly defend it as your faith :) )

Let’s consider
an analogy – let’s say you are a sculptor who likes to make figures using wood,
stone and other materials. Let’s assume you are exceptionally good at making
stone sculptures, but not so great on wood. You go to an exhibition and see
some great wood figures and happen to meet the artist. The artist tells you
about his techniques and the tools he uses. Assuming you want to get better on
wood, will you start laughing at this artist and belittle his tools?

In a similar
fashion if you are a deep value investor, what should be your reaction to the
success of investors who buy and hold seemingly overvalued stocks?

Durable success

I know what the
first objection is to this line of thinking – The success of these investors is
just dumb luck. These guys are not really practicing value investing, but a
form of momentum investing. It is just that the momentum has lasted for 5 years
in some of these cases, and sooner or later this bubble would burst.

My counter
point – sure that is possible, but what if this bubble has lasted for 10-15
years in some cases. Will you still just wave away these anomalies and label
them as flukes?

I prefer to
take a different approach. There is no religious debate to this in my mind – if
something has worked for 3+ years in the stock market, then it is worthy of
investigation. A lot of bubbles and temporary fads usually get washed out in
2-3 years and so 3 years is good cutoff point.

Why not 5 years?
Well now we are moving from the physical to the meta-physical :) and debating the nature
of reality.

So what can one
learn from this oddity where some companies manage to sell for seemingly high
valuations for a very long time.

New business model or value capture

I think the first
point to look for is whether there is a change occurring in the business model/
design, wherein due to changing customer needs and priorities, a new type of
design is now more suited to meet them more profitably.

I would recommend
reading the book – value migration, which goes over this concept in
quite a bit of detail. The main point is that changing customer needs and
priorities cause a change in the business design best suited to meet them.
Companies which can identify and develop a business model to meet this new
reality are able to accrue a lot of value for their shareholders.

For example, a rise
in the income levels has caused the retail consumer to now value quality, brand
image and convenience in addition to the price. As a result, companies which
can meet this new set of needs have been able to create a lot of value.

It is easy to see
this phenomenon around us – Bathroom fittings, automotive batteries, garments
etc. Some of these products were commodities in the past, sold largely based on
price. However increasing consumer purchasing power has meant that the
priorities have shifted beyond price. Companies which have been able to adapt
their business model to deliver on these new priorities of brand, quality and
convenience in addition to price have delivered exceptional returns

It
is not sufficient to be able to meet the changing needs of the consumer, better
than the competition. For starters, the opportunity size should be large so
that the company can grow for a long time to come.

This
is a major advantage of the Indian markets over almost all other foreign
markets. Even niches in India have a market size running to millions of
consumers and hence a company which can build a good business model can easily
grow for years to come.

An
additional point to keep in mind is the need for the company to develop a
durable competitive advantage. Let’s take the case of the telecom industry in
the early 2000s. The need for communication and mobile telephony was recognized
by a few companies such as Airtel in the late 90s and these companies moved in
quickly to satisfy the needs.

The
market size was in the 100s of millions and most of the telecom companies were
able to scale rapidly. However the edge or competitive advantage turned out to
be transitory and as a result after a few years of high profitability, we soon
had a lot of price based competition. As a result by 2007-08, most companies
were losing money and did not create (actually destroyed) wealth.

In
such cases seemingly overvalued companies were truly overvalued.

Kings of their domain

A
productive area for finding multibaggers is in the microcap space, where the
company operates in a niche and is growing rapidly as its business model is
uniquely suited for that niche. In addition, the niche is large enough for the
company to grow for a long time, yet not so big that it attracts large
companies initially.

There
are a few examples which come to my mind – Think of air coolers a few years
back (symphony), CPVC pipes (Astral poly) or various niches in pharma and
information technology.

A
small company develops a unique set of skills for this specific segment and is
able to dominate and grow within the segment for a long time. In addition as
the niche is quite small, it does not attract much competition till it reaches
a certain size.

However
by the time the niche is big enough to catch the attention of larger companies
in the overall space, it is too late as the specific company has established a
dominant competitive position and cannot be dislodged.

A
lot of these companies appear to be overpriced after they have started growing,
but this ignores the possibility of above average growth and a dominant
position for the company.

Capacity to suffer

This
is a term used by Thomas Russo (see talk here) to describe companies which are
capable and willing to make investments in the business for the long term, even
though it penalizes the profits in the short term.

In
most cases, due to market pressures, companies are not willing to hurt short
term profitability to build the business for the long term and hence the few
companies which are willing to do so, appear to be overvalued due to depressed
profits.

Look
at the example of Bajaj corp (an old holding which I have since exited). The
company acquired no-marks brand in 2013 and started deducting the brand value
on their P&L account. In reality the brand value is actually going up as
the company continues to spend heavily on advertising (17% of sales) and hence
the profits are understated.

The
market did not like this short term penalty and punished the stock in 2013. The
stock price has since recovered and we have a company which appears to
overvalued due to the high investments in the business.

I do
not have an example in the Indian markets, but will try to explain this using
the example of a well know US company. Its 2004 and a well-known company called
google decides to launch its IPO at a then PE of around 65. A cursory look
shows the company to be grossly overvalued and as a result most of the value
investors tend to give it a pass.

The
company has since then delivered a return of around 26% p.a and I am sure this
qualifies as a great return. So why did a company which appeared so overvalued
turn out to be a 10 bagger.

My
own understanding is that this result came about from multiple factors. To
begin with, the company operates in a winner take all kind of a market where
the no.1 company tends to dominate and capture almost all of its value. Once
google had a 60%+ market share, the network effects kicked in and the company
just kept getting more dominant in the search space.

Once
this base was built, the company extended it to other platforms such as mobile
where the next leg of growth has kicked in. These type of companies also have a
very low marginal cost of production and hence any growth beyond a threshold,
drops straight to the bottom line.

This
however does not explain fully the reason behind its success – We have a
management which in the words of Prof Bakshi in this note – are
intelligent fanatics and also have the capacity to suffer (as referenced by
Thomas Russo). As a result they have continuously invested in long term ideas
(called as moonshots) even if it meant losses in the near term. You tube,
android etc which are now bearing fruit were drains at one point of time.

Such
companies have been referred as platform companies and usually appear highly
overvalued in the early stages of growth. Another similar company seems to be Facebook.

A
point of caution – For every successful platform company, there are atleast 10
pretenders which destroy value. So it is not easy to identify such companies
ex-ante (atleast for me)

Rate of change matters

Let
me introduce a new concept – business clock speed which I read here. This is the rate at which a
business is changing. For example the rate of change in the social media
business is high and conversely there are business such as paints or
undergarments where the rate of change is low.

I
think it is quite obvious that businesses with low rate of change can create a
durable competitive advantage for the long term and hence a seemingly high
price turns out to be cheap.

On
the contrary very few high change businesses (google, Facebook being a few
exceptions) turn out to justify their sky high valuations.It is difficult to
establish a strong competitive position in an industry where the basis of
competition keeps changing every few years – Just look at IBM which has had to
re-invent itself almost every decade to stay in business and grow its value.
For every IBM, there is DEC or Sun microsystems which did not make it.

It is quite rare

It
is important to understand at this point that it is quite rare to find
overvalued companies, which in hindsight turn out to be undervalued. A lot of
overvalued companies, actually turn out to be just that and so it is important
for a value minded investor to be cautious about such companies.

In
addition it is not easy to identify such companies upfront (there are no simple
screens for it) and one has to think deeply to develop the right insights to
buy and hold such companies.

So why study ?

As I
stated in the beginning of this note – If you want to be a successful investor,
it is important to have as many mental models in your head. Investing in a
cheap, low valuation companies is one such mental model. However this does not
mean one should just wave away any company which is selling at a high price.

The
advantage of understanding the drivers of success is that the next time when
you are evaluating a company, it makes sense to check if this company fits into
any of these models? One can ask some of these questions

-Is the company overvalued simply
because the management is investing in the business for the long term which has
suppressed the near term profits?

-Is the company developing a new
business model which meets the changing requirements of the consumer much
better than competition

-Does the company have a durable
advantage and a large opportunity space (the case for a lot of FMCG companies
in India)

-Does the company have network effects
or is it a platform company run by an intelligent fanatic?

-Has the company identified and
developed a unique business model for a niche which it will dominate for a long
time?

My
post above does not cover all possible reasons why a seemingly overvalued
company, will turn out to be cheap. There is no standard formulae or screen
which will give you the answers. One has to study the company and the industry
deeply to develop any useful insights (as fuzzy as they may be).

Inspite
of the odds, if however if you do manage to get it right, it would be stupid to
sell the company based on a PE ratio which appears higher than normal.
----------------Stocks
discussed in this post are for educational purpose only and not
recommendations to buy or sell. Please contact a certified investment
adviser for your investment decisions. Please read disclaimer towards
the end of blog.

18 comments:

mkd
said...

Rohit,

Let me be the first to comment - Fantastic post!!

Distilled gyaan from multiple models, all woven together neatly in a simple and easy to understand post. This is the reason it is always a pleasure to read your blog and I wish you would blog more often.

Coming back to topic, I wonder if you have come across any study which talks about probabilities of capital loss for these various models. I assume it would be different across all these situations and if one understands them well she could apply it for payoff calculations and position sizing as well.

e.g. In a platform kind of business with winner takes all, assuming only 1 out of 10 companies succeeding, an investor could expect to lose 70-100% of investment capital in 9 out of 10 cases. This would probably dictate the percentage of portfolio which can be realistically allocated to such ideas while controlling the risk of capital loss. If its a small percentage, even after earning high rate of return it may not matter much at portfolio level compared to a business following a boring model, promising a lower rate of return but with possibilities of much higher allocation possibilities due to higher chances of success (and lower chances of capital loss).

dear rohit,wonderfully expressed all my views in your words. firstly, debate is because when you hold a stock which is overvalued , the price correction is sometims very sharp. then, we look back to see if we did not take advantage of a transient market ineffeciency eg cer correcting by 50%secondly , more painful is how undercvalued is a undervalued comapany and for how long--- eg ricoh, fdc, mayur, . here we lose big time.thirdly, do we let go transient but massive mispricing eg textile stocks, mid cap pharma where value was very very obvious.although , a disciple of yours i want to make money always and also be rich. so, i look for all multiples to a 100x( 10x10, 5x20 etc).phelps with multiplication and market cycle churning always helps since it is natural

dear rohit, high PE investing is all about the risk you want to take to prove your hypothesis. if your knowledge advantage mitigates the risk, you are safe. but, as graham pointed out , you are safest when all the three components of an investment indicate safety- industry/ company, your gut, and the market. and high PE fails there.

I have not looked at the probabilites of each model, as my aim is to first look at some common patterns. also its not easy to find the base rate in each case.i look at each of these models more like a point of view or tool to see where the company is going. for example, a platform company is a type of company with google and facebook being pure example. but we can have companies where they may not be a pure platform business but still have those characteristics.

in such cases, even if i dont have the exact probabilities, thinking of the company in that sense will show me that the growth possiblities are much higher and hence a seemingly high valuation is not too high and the business is more fairly priced.

so most of these models are more different lens to view a company and not really a precise approach to value it

hi madhuits comes down if you can play both the approaches well. if you can jump in and out of undervalued positions, all the better. i dont find that easy for me and too much of a headache. buy and hold has worked better for me.

does it mean a few % less returns ..sure , but i am happy with what i make :) adding a few extra % and being miserable does not work for me. i feel sick in my stomach literally when i hold crappy companies even if they eventually make money for me. that does not mean it will not work for others

hi anonyou are missing the point. a high PE in an of itself does not mean overvaluation ...it could be but not always and that the point of my post.

undervaluation in all aspects is a wonderful thing and we had that in 2013, but not now..atleast its not pervasive. so if you can be patient and wait for that kind of situation to come back, then its fine.

also graham type of investing does not work as well in india. if you run graham filters most of the time one get horrible biz with bad managements. also overall returns are lower. finally what was a deal breaker for me was that i felt sick in my stomach when i held such lousy companies. so i have realised my temprament does not work for really cheap companies

Can we apply the same logic to Mumbai real estate price? It has been almost 8-10 years and the market is expensive. Many believe that there will be a price correction in real estate prices; however it just doesn’t come up.

In that case, it is quite possible, that the expensive price is actually the right price and the market is discounting the future growth in infra in Mumbai correctly.

I thought that there should be a price correction about 5 years back but it has almost tripled since then.

Excellent post. As an investor who started very staunch value guy, I realized over time that such "rigidity" does not help at all. One should be flexible in at least understanding various models that works and why the work. The expands your horizon and will help you decipher some excellent insight that you can apply in future. Many a time, when you experiment, it also yields you good results and hence your opportunity set expands over time. You have very clearly outlined "why" it is worth undertaking such exercise.

Really interesting point. One company that I feel really fits in this example is Eicher motors. The brand has a phenomenal equity and I feel it will retain this competitive advantage for some time till some of the indian players develop products in its segment or a foreign player enters in a really big way. Currently the stock seems to be way overpriced but something I am definitely interested in. Few points working in its favor

1. The motorcycle business is growing faster than CV business and is more profitable. This has been driving constant margin expansion

2. With its waiting period due to high brand pull the business runs on negative working capital cycle.

3. ROCE numbers kind of indicate presence of a MOAT (brand has near monopoly in 150K + bike segment) which is likely to last for sometime atleast.

4. CV business though slowing down is still profitable and indications are of cycle turning.

My five cents on the subect. Finding such great companies that deserve being expensive is a really tricky task. I mean just imagine going back in time when such a company was just getting by and ask yourself if the outcome of its decisions were in any way predictable. If not, you are probably seeing patterns in hindsight where there was only chaos in the moment.

"I have never quite understood the point of these debates. There is obviously no single way of making money in the stock market. There are short term traders, buy and hold guys, debt specialists and all kinds of people in-between. Each approach has its strengths and weaknesses and no one can claim that a specific approach is inherently superior to the other, unless they are equally proficient in both."

That is a good point, and I totally agree. The only problem is that most investors haven't got a clue who they are as an investor. To what category they belong.

I really think that most people would be better off, first sitting in a room alone, doing nothing and figuring out who they really are as an investor, i.e. getting to know themselve. And than start in the endavor of value investing.

I recently have written a post on that subject on my blog, which could be of interest to you.

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I do not provide investment advisory service via this Blog. The stocks discussed on the blog and each post are for educational and discussion purposes only and are not recommendations to buy or sell stocks.I may or may not have a position in the stocks discussed on this blog. For any investment decision, please contact a certified investment advisor.